What Are Passive Mutual Funds? Meaning, Types and Investment Strategy

Investors often emphasise asset allocation and diversification strategy while investing in mutual funds; but another factor that needs to be taken into consideration is the type of investment approach you choose, i.e. active or passive. This could have a bearing on the returns in your mutual fund portfolio.

There are strong viewpoints on the advantages of the two mutual fund investment strategies, active investing and passive investing. However, during the past few years, the demand for passive investing in mutual funds has increased. . By investing in and following a certain benchmark or index, passive investing gives investors access to particular market cap indices, strategy indices, or thematic/sector indices. In passive investing, the fund manager replicates a specific benchmark or index, such as the S&P BSE Sensex, Nifty 50, Nifty Next 50, Nifty DIV OPPS 50, Nifty India Consumption, etc. and aims to hold a similar composition of securities as the respective underlying index. The simplest way to invest in Mutual funds is through passive investing.

What is Passive investing?

The goal of passive investing is to mirror the performance of an index or benchmark; as a result, it does not outperform the benchmark. The passive investing strategy generates optimal index-linked returns at a lower cost as compared to active investing.

This article elucidates the potential of passive investing in order to help investors better understand the finer nuances of passive investing and how to use the style within their portfolio to optimise their performance. In highly volatile times -- like the one we're currently experiencing -- passive investing might be a wise course of action. Also, for a novice investor who does not possess the knowledge on how to choose amongst actively managed mutual fund schemes, ‘Passive mutual Funds’ may be a worthwhile choice.

What are Passive mutual funds?

A Passive mutual funds simply replicates the respective benchmark index it follows. That said, it still offers diversification through exposure to a range of securities across sectors within the respective index.

Additionally, it offers low-cost investment options for individuals seeking market-linked returns in line with the relevant benchmark index. The fund manager passively manages the portfolio by seeking to replicate the underlying benchmark, thereby reducing the fund manager’s involvement or any behavioural biases.

Since various mutual fund houses have started to prioritise passive investing and are developing a variety of themes and new investment strategies in the passive space, passive mutual funds have formally found their way into the portfolios of many retail investors in recent years.

Two common ways of investing in passively managed mutual funds are to either opt for an index fund or an exchange-traded fund (ETF). Both are the main vehicles of passive investing that essentially replicate an index. 

Index Funds and ETFs – Types of passive funds

Index Funds and Exchange-Traded Funds (ETFs), Index Fund of Funds, Smart Beta ETFs are types of passive funds. They are designed to replicate broad indices like the S&P BSE 500 or any other specific index and provide investors with exposure to a diversified fund across sectors. These are passively managed funds that merely replicate an underlying index's performance while limiting fund managers' intervention, subject to tracking errors.

While the units of index funds are bought and sold like any common mutual fund scheme, the units of ETFs are traded on the stock exchange. Under the Quantum Nifty 50 ETF (QNF), the stocks that form a part of the NIFTY 50 index (consisting of 50 large-cap Indian companies across 13 sectors) also form a part of QNF’s portfolio in the same proportion.

The growth in passive investing has not only been limited to equity funds but has extended to debt and commodities as well. Recently, silver-based ETFs were introduced in the Indian market, and a blend of silver and gold ETFs have also been launched.

Although passive investing in mutual funds is one of the matured segments globally, it is still at a nascent stage and gaining traction in India. Another type of mutual fund that involves a passive investing strategy is Fund of Fund schemes.

Fund of Funds

A ‘Fund of Funds’ (FOFs) passively invests in other mutual funds rather than investing directly in stocks, bonds or other securities. Fund of Funds offers a portfolio of equity funds picked by professional fund managers and their team, who even tracks the performance closely.

By investing in different mutual funds, which in turn invests in different underlying asset or asset subclass, offers the benefit of diversification and reduces the concentration risk. This is also a great medium of investment for beginners in mutual funds who don't have expertise in selecting equity funds themselves.

The Quantum Nifty 50 ETF Fund of Fund is mandated to invest in units of the Quantum Nifty 50 ETF, which replicates the Nifty 50 index that tracks India’s top-50 companies

Furthermore, considering the emergence of passive mutual funds as an investment product for retail investors, the market regulator SEBI has now permitted the establishment of a passive Equity-Linked Savings Scheme (ELSS).

Although passive investing in mutual funds may seem like a wise option, many investors are still having a debate over the broad differences between Active and Passive Investing.

Should you consider Active mutual funds or Passive mutual funds?

The active vs passive mutual funds have long been debatable, but ultimately the investor's risk tolerance, time horizon, and goals determine which investment style is best suitable for them.

An actively managed mutual fund has a manager who dynamically manages assets, attempting to make the most of the market conditions and generate alpha (outperforms its benchmark). Passive funds, on the other hand, do not need regular management. The idea is to simply replicate the benchmark index. They mirror the market, right down to the last trade, in essence. Therefore, passive mutual funds manage to provide returns that are similar to the underlying benchmark instead of outperforming the index.

Do note that actively managed mutual funds involve  buying and selling of securities, thereby increasing transaction costs and fund management fees. This makes it a high-cost investment. Actively managed mutual funds involve stock selection and could attract the risk of behavioural bias.

On the other hand, passive mutual funds are low-cost and affordable as compared to active investing. Passive mutual funds eliminate any such risks due to limited intervention by the fund manager.

With the gaining importance of passive investing, the opportunities look bright for passive mutual funds. But keep in mind that passive mutual funds more or less deliver returns in line with the benchmark.

To conclude

If you’re a beginner in mutual funds, a passive investing strategy can be an ideal option for you since it doesn't require much in-depth knowledge of the portfolio characteristics of the scheme.

Happy Investing!

Above article is authored by Quantum.

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